In 2011, the Washington commercial real estate market sent mixed signals. Office rents generally declined, while apartment rents rose. Investors experienced great returns, even as the federal government — one of the market’s key drivers — was curtailing its demand for office space.
What will 2012 bring? We have identified several megatrends and opportunities in the local economy and commercial markets.
1: Uncertainty. A sense of uncertainty has increased of late, driven largely by the debate surrounding the federal budget. This uncertainty is affecting consumer spending, business investment, decision-making in general, tenant leasing, and commitments of all types — thus slowing economic growth.
2: Drive to efficiency. With consumers and businesses uncertain about future economic conditions, many are taking steps to become more efficient — doing more with less. Companies are taking less office space per employee, shedding unneeded office space or right-sizing, and using profits to invest in software and other productivity measures. Consumers are downsizing into smaller homes, and increasingly cohabitating. Welcome to the “Era of Less.”
3: Flight to quality. Tenants with cash and demand for office space are taking the opportunity while rental rates remain compressed to upgrade to Class A space. High-end apartments are also outperforming those of lesser quality. The number of Class B units undergoing renovation in the Washington area has increased by several thousand units over the past year, as investment conditions have improved.
4: Increasing flexibility. At the national level, during the run-up to the housing market bubble of 2004-05, homeownership rates reached a cyclical high of 69.2 percent. As the bubble burst in 2006-07, people increasingly turned back to rentals. One reason was that owning a home, once seen as a safe investment, had instantly become a financial risk. Another was that some homeowners were forced into short sales or foreclosures, and could not afford to buy again. But a third — which gained momentum as the recession hit with full force in 2008 — was that a flexible lifestyle is an asset. Whether because of the reduced financial commitment involved in renting vs. owning, or the increased ability to move to where the jobs are, renting has become more attractive. By 2011, the rate of homeownership in the United States had declined to 66.0 percent.
In the Washington area, we believe that this shift away from homeownership is moderating, at least locally.
5: Preparing for federal budget cuts. Historically, 30 percent or more of the region’s gross regional product has been due to federal spending. This share jumped to around 40 percent in 2010. Given current austerity measures, we expect this share to decline to around 36.3 percent by 2015.
These “cuts” to projected spending — really just a decelerating rate of growth — are not likely to derail economic growth in the region. But they will certainly slow it well below our experience of prior recovery cycles.
6: Private sector growth. The Washington area has become proficient in attracting associations and corporate headquarters from other parts of the country. That is likely to be a continuing source of local job creation. But we also see more jobs in the lobbying/legal sectors because with a smaller federal pie, there is bound to be more fighting over the slices. The greatest sources of local job growth are likely to be in the professional/business services and education/health fields. Technology-focused jobs that straddle the line between professional services and information also will drive the market.
7: Thirst for yield. In 2011, the average investor in core commercial real estate saw strong returns — better than any alternative. As measured by the NCREIF Property Index, returns on commercial real estate for the 12 months ending in December 2011 were 14.26 percent — far exceeding the performance of the S&P 500, which returned 2.11 percent for the same period. Bonds returned 9.02 percent over the same span.
Where is value going to come from in 2012? The likely answer is in the nature of what has been selling recently. Class B/C office and apartment assets out-sold Class A assets (based on unit volume) during 2011.
What are the opportunities in the Washington market that stand out as most appealing in 2012 and beyond?
1. Finance assets with long-term fixed-rate loans while interest rates are low. We expect rates to remain low into 2013, based on the sluggish economy and the Fed’s position on short-term rates.
2. Reposition Class B properties into Class A. With tenants across the board seeking to reduce costs while stepping up in quality, upgrading offices or apartments from Class B to Class A, is a good way to attract tenants as the expansion cycle emerges.
3. Selectively develop apartment, condominium, and retail projects. Planned residential projects should be focused on underserved markets and incorporate special features in order to stand out. retail sector also has rebounded smartly, with spending growth concentrated in two disparate categories: luxury goods and discount goods.
4. Modernizing and better managing existing assets. Making buildings more efficient through sustainability initiatives not only can improve net operating income, it can make those properties more attractive to would-be tenants.
5. Selectively acquire well-leased Northern Virginia office assets to take advantage of the recent softening in pricing. Demand is likely to grow as new technology jobs are added in the Dulles Corridor and tenants seek space near the new Tysons Corner Metro stations.
6. Take advantage of new infrastructure. Projects we once thought of as long term are nearing completion, from BRAC facilities, to the High-Occupancy Toll lanes in Virginia, to the Metrorail’s Silver Line out to Tysons Corner and Reston, to the Intercounty Connector n Maryland. While many of the prime opportunities to co-locate near new infrastructure have been snapped up, others remain available to properly-funded developers and investors. Given the cost and time to build new infrastructure assets, opportunities like these are rare. Also, there are potential future infrastructure assets to bet on: the Purple Line, streetcar lines, a soccer stadium, and more.
Sandy Paul is the national research director at Delta Associates, the research affiliate of Transwestern. Staff at Delta Associates contributed to this article. For expanded analysis of the trends and opportunities identified in this article, please see Delta’s annual TrendLines publication and presentation, both of which are available at www.deltaassociates.com.